The Quiet Panic in Hong Kong (April 2019)

The Economics Behind Currency Boards/Pegs
The harsh reality is that economic relationships between pegged regimes must be harmonized or they are
destined to fail. Norman Chan, the soon-to-be-retired CEO of the HKMA, admitted this in 2017 when he
set the four conditions that need to be present for the Hong Kong Dollar to be reset and re-pegged to the
Chinese RMB.
Business cycles and economies must be synchronized or stresses will emerge in the fixed nature of a
currency board or peg. If one of the economies is growing while the other is contracting (one demands
higher interest rates while the other needs lower interest rates), the resultant lack of synchronicity of
pegged economies in a rigid exchange regime builds pressure-cooker like imbalances over time. The
economy that has elected to peg (HK) to the anchor currency (USD) must import (or mirror) the monetary
policy (primarily interest rates) of that country. This means that if overnight rates diverge between the
two, the divergence will cause large capital flows one way or the other, which immediately puts pressure
on the currency board/peg. On the strong side of the peg (ie when outside capital is flowing into the
pegged currency), the central bank can easily flood the system with liquidity (print local currency) to lower
rates and discourage additional capital flows into the pegged currency. On the weak side of the
board/peg, the pegged regime can spend available excess reserves (think rainy day savings) to defend the
peg. If currency boards were perfect, the Argentinian Peso would be still be 1-to-1 to the US Dollar like it
was in 2001. Instead, today it takes 43 pesos to buy one dollar.
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© Hayman Capital Management, L.P. 2019